How is volatility calculated
First<![if !vml]><![endif]>of all you need to find the average monthly return on an investment. To do this you add up the monthly returns on an investment and then divide by the number of months.
When people measure volatility they try to use a long enough period of time to ensure that the movements in price reflect the actual risk of the investment and not short term stock market conditions. This means most volatility is calculated using data going back over at least the last 5 years and often longer.
Step 1 - Find the average return
The following chart shows the monthly returns on an investment (red line) and the average monthly return (blue line).
Step 2 - Find the difference between the monthly return and the average return
The next step is to find the difference between the actual monthly return and the average monthly return. For example, in month 17 the return is 5% and the average return is 3%, the difference is 2% and if the return in month 7, was -7, the difference would be 12. You would do this for every month.<![if !vml]><![endif]>Step 3 - Find the average of the differences
This difference is noted by the red line in the following chart. Volatility, is the average of these differences, or the blue line. All we do is add the differences and divide by the number of months.
The more volatile an investment is, the more risky it tends to be.
However, as you will note, the blue line (volatility) is not as volatile as the red line and does not tell you the actual risk your are exposed to at a point in time. For example the investment represented by the above graph was actually 4 times as risky as its volatility at its most risky point.
During periods when markets are highly valued, this simple measure of risk significantly understates the risks to which investors are exposed; the above understates this risk by a factor of 4. Portfolios and financial security need to be built upon a wider and stronger risk management mandate.